Investing Basics – MM Funds and Municipal Bonds

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Money Market Funds

Money market funds are a type of mutual fund that invests in high quality short-term debt. They pay dividends that generally reflect short-term interest rates. Money market funds try to maintain a stable value called a “net asset value” or NAV, typically $1.00 per share. Many investors use money market funds to store cash, or as an alternative to investing in the stock market.
Money market funds should not be confused with deposit accounts at banks. Bank accounts are federally insured up to $250,000. An investment in a money market fund has no federal guarantee against losses.

Money market funds are considered to be a fairly safe investment; however, there are risks and fees. While the fund’s managers try to keep the NAV stable, the yield changes over time. These changes generally reflect changes in short-term interest rates.
If the fund’s NAV falls below $1.00 a share due to losses in the underlying investments, it is called “breaking the buck” and investors who sell their shares will lose money. Also, if short-term interest rates are very low, it is possible that fees that investors pay will exceed the income earned on fund investments. As with any investment, you should consider the impact of fees on your investment.

Municipal Bonds

Municipal bonds (or “munis” for short) are debt securities issued by states, cities, counties and other governmental entities to fund day-to-day obligations and to finance capital projects such as building schools, highways or sewer systems. By purchasing municipal bonds, you are in effect lending money to the bond issuer in exchange for a promise of regular interest payments, usually semi-annually, and the return of the original investment, or “principal.” A municipal bond’s maturity date (the date when the issuer of the bond repays the principal) may be years in the future. Short-term bonds mature in one to three years, while long-term bonds won’t mature for more than a decade.

Generally, the interest on municipal bonds is exempt from federal income tax. The interest may also be exempt from state and local taxes if you reside in the state where the bond is issued. Bond investors typically seek a steady stream of income payments and, compared to stock investors, may be more risk-averse and more focused on preserving, rather than increasing, wealth. Given the tax benefits, the interest rate for municipal bonds is usually lower than on taxable fixed-income securities such as corporate bonds.

The two most common types of municipal bonds are the following:

General obligation bonds are issued by states, cities or counties and not secured by any assets. Instead, general obligation are backed by the “full faith and credit” of the issuer, which has the power to tax residents to pay bondholders.

Revenue bonds are not backed by government’s taxing power but by revenues from a specific project or source, such as highway tolls or lease fees. Some revenue bonds are “non-recourse”, meaning that if the revenue stream dries up, the bondholders do not have a claim on the underlying revenue source.

In addition, municipal borrowers sometimes issue bonds on behalf of private entities such as non-profit colleges or hospitals. These “conduit” borrowers typically agree to repay the issuer, who pays the interest and principal on the bonds. In cases where the conduit borrower fails to make a payment, the issuer usually is not required to pay the bondholders.